Tax Tip for May 2001
Taxation of
social security benefits
How Social Security benefits are
taxed depends on your other income. In the worst case scenario, 85% of your
benefits would be taxed. (This doesn't mean you pay 85% of your benefits back to
the government in taxes—merely that you would include 85% of them in your
income subject to your regular tax rates.)
To determine how much of your
benefits are taxed, you must first determine your other income, including, for
this purpose, tax-exempt interest. Add to that the income of your spouse, if you
file jointly. To this add half of the Social Security benefits you and your
spouse received during the year. The figure you come up with is your total
income plus half of your benefits. Now apply the following rules:
1. If your income plus half your
benefits is not above $32,000 [$25,000 for single taxpayers], none of your
benefits are taxed.
2. If your income plus half your
benefits exceeds $32,000 but is below $44,000, you will be taxed on (1) one half
of the excess over $32,000, or (2) one half of the benefits, whichever is lower.
Example (1): Sam and Denise
have $20,000 in taxable dividends, $2,400 of tax-exempt interest, and combined
Social Security benefits of $21,000. Thus, their income plus half their benefits
is $32,900 ($20,000 plus $2,400 plus 1/2 of $21,000). They must include $450 of
the benefits in gross income (1/2 ($32,900 − $32,000)). (If their combined
Social Security benefits were $5,000, and their income plus half their benefits
were $40,000, they would include $2,500 of the benefits in income: 1/2 ($40,000
− $32,000) equals $4,000, but 1/2 the $5,000 of benefits ($2,500) is
lower, and the lower figure is used.)
[For single taxpayers substitute
the following for the above:
2. If your income plus half your
benefits exceeds $25,000 but is below $34,000, you will be taxed on (1) one half
of the excess over $25,000, or (2) one half of the benefits, whichever is lower.
Example (1A): Sam has
$20,000 in taxable dividends, $2,400 of tax-exempt interest, and Social Security
benefits of $9,000. Thus, his income plus half his benefits is $26,900 ($20,000
plus $2,400 plus 1/2 of $9,000). He must include $950 of the benefits in gross
income (1/2 ($26,900 − $25,000)). (If his Social Security benefits were
$3,000, and his income plus half his benefits were $30,000, he would include
$1,500 of the benefits in income: 1/2 ($30,000 − $25,000) equals $2,500,
but 1/2 the $3,000 of benefits ($1,500) is lower, and the lower figure is
used.)]
3. If your income plus half your
benefits exceeds $44,000 [$34,000 for single taxpayers], the computation in many
cases grows far more complex. Generally, however, unless your income plus half
your benefits is fairly close to $44,000 [$34,000 for single taxpayers], if you
fall into this category, 85% of your Social Security benefits will be taxed.
Caution: Since
the higher your income the more of your Social Security benefits that are taxed,
an unplanned increase in your income can have a double tax cost. You'll have to
pay tax (of course) on the additional income, but you'll also have to pay tax on
more of your Social Security benefits. And you may get pushed into a higher
marginal tax bracket. This situation might arise, for example, when you receive
a large distribution from a retirement plan during the year.
Example (2): Assume the
same facts as in Example (1), above, for 2001, except that towards the end of
the year Sam and Denise pull $25,000 out of their IRA, in order to give their
son cash for a down payment on a new home. The IRA withdrawal adds $25,000 to
their income. Taking into account only this $25,000 of additional income, they
would still be in the 15% tax bracket. So they would expect to pay $3,750
additional tax (15% × $25,000). However, in this scenario, under the rule at 3
above, 85% of their combined Social Security benefits ($17,850, i.e., combined
Social Security benefits of $21,000 × 85%) is now taxable, because their total
income plus half their combined Social Security benefits is $57,900 (that is,
$20,000 in taxable dividends, plus the $25,000 IRA distribution, plus the $2,400
of tax-exempt interest, plus one-half of the $21,000 Social Security benefits,
or $10,500), which exceeds $44,000. As a result, their total taxable income is
increased not only by the $25,000 IRA distribution itself, but by an additional
$17,400—the amount of the increase in their taxable Social Security benefits
($17,850 − $450 [the amount of their taxable Social Security benefits if
there hadn't been an IRA distribution, see Example (1) above]). In addition, Sam
and Denise are now pushed into the 28% marginal tax bracket. So their total tax
increases by $6,678 ($7,466 − $788, see calculation below). (Looked at
another way, their IRA distribution is in effect being taxed at a 28% rate.)
Here's how the tax is affected by the distribution: No distribution With
distribution Adjusted gross income: Dividends $20,000 $20,000 IRA distributions
— 25,000 Taxable Social Security benefits 450 17,850 $20,450 $62,850 Less:
Exemptions, standard deduction and additional standard deductions for the
elderly for 2001 15,200 15,200 Taxable income $5,250 $47,650 Tax (per 2001 Tax
Rate Schedule) $788 $7,466 Top tax rate 15% 28%
No With distribution distribution -------------------------------------------------------------------- Adjusted gross income: Dividends $20,000 $20,000 IRA distributions -- 25,000 Taxable Social Security benefits 450 17,850 ------- ------- $20,450 $62,850 Less: Exemptions, standard deduction and additional standard deductions for the elderly for 2001 15,200 15,200 ------- ------- Taxable income $ 5,250 $47,650 Tax (per 2001 Tax Rate Schedule) $ 788 $ 7,466 Top tax rate 15% 28%
[For single taxpayers substitute
the following Example 2A for the above Example 2:]
Example 2A: Assume the same
facts as in the above example for 2001, except that towards the end of the year
Sam pulls $25,000 out of his IRA in order to give his son cash for a down
payment on a new home. The IRA distribution adds $25,000 to Sam's income.
However, under the rule at 3 above, 85% of Sam's Social Security benefits
($7,650, i.e., Social Security benefits of $9,000 × 85%) is now taxable,
because his total income plus half his Social Security benefits is $51,900 (that
is, $20,000 in taxable dividends, plus the $25,000 IRA distribution, plus the
$2,400 of tax-exempt interest, plus one-half of the $9,000 Social Security
benefits, or $4,500), which exceeds $34,000. As a result, Sam's total taxable
income is increased not only by the $25,000 IRA distribution itself, but by an
additional $6,700—the amount of the increase in his taxable Social Security
benefits ($7,650 − $950 [the amount of Sam's taxable Social Security
benefits if there hadn't been an IRA distribution, see Example (1A) above]). And
so Sam's total tax increases by $6,972 ($8,832 - $1,860, see calculation below).
(Looked at another way, Sam's distribution is in effect being taxed at an almost
29% rate.) Here's how the tax is affected by the distribution: No distribution
With distribution Adjusted gross income: Dividends $20,000 $20,000 IRA
distributions — 25,000 Taxable Social Security benefits 950 7,650 $20,950
$52,650 Less: Exemption, standard deduction and additional standard deduction
for the elderly for 2001 8,550 8,550 Taxable income $12,400 $44,100 Tax (per
2001 Tax Rate Schedule) $1,860 $8,832 Top tax rate 15% 28%
No With distribution distribution -------------------------------------------------------------------- Adjusted gross income: Dividends $20,000 $20,000 IRA distributions -- 25,000 Taxable Social Security benefits 950 7,650 ------- ------- $20,950 $52,650 Less: Exemption, standard deduction and additional standard deduction for the elderly for 2001 8,550 8,550 ------- ------- Taxable income $12,400 $44,100 Tax (per 2000 Tax Rate Schedule) $ 1,860 $ 8,832 Top tax rate 15% 28%
Careful planning could have
avoided the stiff tax bill resulting from the IRA distribution. The withdrawal
could have been spread out over more than one year. Another way to save in taxes
is to liquidate assets other than an IRA account, such as stock showing only a
small gain or stock whose gain can be offset by a capital loss on other shares.
If you should need a large amount of cash for a specific purpose, please contact
me before pulling money out of a retirement savings account so that the best
method of raising the cash can be determined.
If you know your social security
benefits will be taxed, you can voluntarily arrange to have the tax withheld
from the payments by filing a Form W-4V. Otherwise, you may have to make
estimated tax payments.
Please contact us if you'd like us
to run some specific numbers for you, or if you would like to discuss this
matter further.
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